When the Fed does raise rates, this will be the guy behind the curtain

(Bloomberg) — Whenever the Federal Reserve decides to raise interest rates, it will turn to a British-born economist named Simon Potter to do the job.

Potter, 54, is in charge of hitting the U.S. central bank's target for the federal funds rate, the key interest rate that the Fed uses for monetary policy. He heads a group of traders at the Federal Reserve Bank of New York who operate from the ninth floor of the bank's imposing, Italian Renaissance-style headquarters in downtown Manhattan.

The rate-setting Federal Open Market Committee could decide as soon as today, at the conclusion of a two-day meeting in Washington, to raise the rate, which has been at a historic low of zero to 0.25 percent since December 2008. If it does, it will reflect the Fed's confidence that the economy is strong enough to withstand costlier money—and its worry that superlow rates could eventually cause inflation to rise above its 2 percent target.

That's where Potter comes in. Although there are 12 reserve banks in the Fed system, New York is primus inter pares, first among equals. Monetary policy is decided in Washington, and hundreds of economists and other Fed experts throughout the Federal Reserve System have been involved in designing new tools to carry that policy out. Ultimately, though, those tools will be put to work in Manhattan by Potter and his team. They operate the plumbing of the U.S. financial system, opening and closing valves to make money flow where the Fed wants it to go.

"Simon is exceptionally capable and experienced, but he and the Fed will be trying to do something that they've never had to do before," says Carl Tannenbaum, chief economist at Chicago- based Northern Trust.

UNCHARTED TERRITORY

The Fed is moving into uncharted territory. It has never tried to raise the federal funds rate—that is, make money harder to get—when the banking system was flush with $2.5 trillion of excess reserves, as it is now. Economists and traders are bracing for gyrations in financial markets when the New York Fed starts to tighten up the rate.

The trouble is, the Federal Reserve can't just declare the federal funds rate and make it stick. The rate is set by market forces. The only thing the Fed can do is influence market conditions to steer the funds rate toward its target.

That's easy to do when federal funds are scarce and there's natural market demand for them. It's much harder today, when the funds are in massive oversupply.

“There are three or four things about how the financial system works that most people didn't understand and didn't really need to understand before 2008,” Peter Stella, who led the central banking and monetary and foreign exchange operations divisions of the International Monetary Fund from 2005 to 2009, told Bloomberg News. “They still don't understand them, so I think there's a lot of risk of volatility when things actually start happening.”

AWARE OF THE CHALLENGE

Potter is well aware of the challenge. "We don't know what's going to happen when we lift off," he said in April, answering questions after a speech to the Money Marketeers of New York University.

Potter wasn't always a master financial plumber. Before taking over the New York Fed's Markets Group in 2012, he was its director of economic research, dealing in heavy-duty economic theory. According to his bio on the bank's website, his research specialty is applied time series analysis using Bayesian methods, and he "has written extensively on nonlinear dynamics over the business cycles." He taught at UCLA, Johns Hopkins, New York University, and Princeton before joining the New York Fed in 1998. He has a bachelor's and a master's degree from Oxford University and a doctorate from the University of Wisconsin. Today, he also manages the System Open Market Account for the Federal Open Market Committee.

"He can do both the technical, abstract, computational statistics and the practical, real-world macroeconomics (unlike me and most of my colleagues)," Gary Koop, an expert in econometrics who has frequently collaborated with Potter on academic papers, wrote in an email. Koop, a professor at the University of Strathclyde in Glasgow, Scotland, wrote that Potter "can switch from having some keen insight into the underlying economics of the problem to telling me why my Metropolis-Hastings algorithm is not working well." (That algorithm is an experts-only technique for statistical analysis in physics and economics.)

Potter's sensitivity to "nonlinear dynamics"—phenomena that don't move in nice, straight lines—should be useful as he tries to carry out the committee's wishes. Brian Sack, director of global economics at the hedge fund D.E. Shaw, who preceded Potter in the job, says nimbleness will be key. "The desk will need some flexibility to respond to market developments in order to meet its objective of controlling short-term interest rates," Sack says. "Simon has done everything you would expect to prepare for using these tools."

The federal funds rate, recall, is the rate that banks charge each other for overnight loans of reserves that are deposited at the Federal Reserve. Ordinarily, banks that have excess reserves lend them to banks that are at risk of having less than the Fed's required level. But now all banks have excess reserves, which they acquired when the Fed bought Treasury bonds and mortgage-backed securities and paid for them by crediting banks with extra reserves. That was an effort to stimulate a recession-stung economy by lowering long-term interest rates.

ONE OF THE FED'S TRICKS

The Fed has already been using one trick to get banks to borrow federal funds despite their overabundance. It pays them 0.25 percent a year on their excess reserves. So banks can borrow at whatever the current federal funds rate is, then turn around and deposit the reserves at the Fed at 0.25 percent for a guaranteed profit. That 0.25 percent rate, known as IOER, for interest on excess reserves, is always going to be set at the high end of the funds rate target.

The IOER is intended to put a floor under interest rates. But it's not 100 percent effective, because not all financial institutions are eligible to deposit reserves at the Fed and receive interest on them. So the Fed is building a floor under the floor.

That's a borrowing arrangement called the overnight reverse repurchase agreement facility. The details are complicated, but the concept is simple: The Fed borrows from a wide range of financial institutions at a set rate. The Fed's borrowing rate serves as a rock bottom: No institution would be foolish enough to lend money to anyone else for less than it can earn by lending to the Fed.

The new borrowing tools—which also include the term repurchase rate and the term deposit facility—cover not only banks but financial institutions such as Fannie Mae, Freddie Mac, the Federal Home Loan Banks, and money market mutual funds that aren't eligible to earn interest on excess reserves. Because they cover a broader range of institutions, they serve as a firmer floor for rates. Rates can and do fall below the rate of interest on excess reserves, but ideally they should never fall below the overnight reverse repurchase rate.

CONFLICTED AND COMPLICATED

One thing that will complicate Potter's life is that the Federal Open Market Committee seems a little conflicted about its new borrowing facilities. It's limiting how much it will borrow at the overnight reverse repurchase rate. If it inadvertently doesn't borrow enough, it may not sop up all the funds that are looking for a home.

In that case, the federal funds rate may indeed fall below the overnight reverse purchase rate—and thus below the Fed's target range. If that happens for too long, it will damage the Fed's credibility and force it to increase its borrowing rapidly.

That's when Potter and his team will truly be tested.

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